If you get a headache, as I do, from the arguments and counter-arguments surrounding the Federal Reserve Board policy known as QE2, you may wish to briefly ponder the lessons of a simpler time – the decade of the 1920s, when the Federal Reserve Board first learned how to moderate the business cycle by buying and selling government securities in the open market.
The Fed was established, in 1913, to create a more “elastic” monetary system, in response to the periodic panics that had seized the US banking system since before the Civil War, but without much legislative guidance as to how to pursue its responsibilities.
For most of its first decade, the Fed relied on two mechanisms to manage the quantity of money in circulation: it bought and sold gold, according to the ebb and flow of foreign trade; and it raised and lowered its “discount rate,” the interest rate at which it lent to member banks.
As early as 1914, it contemplated the use of a further tool – the power to buy and sell short-term government obligations, thus easing and tightening reserves, and so influence, even (perhaps) control, the domestic money market, by affecting levels of bank lending. But in a period of war finance the guidance of the more coarse rudders was enough.
The first open-market operations, in 1922, signaled the beginnings of a new era in the scope of the Fed’s activities, according to Robert Timberlake, writing in Monetary Policy in the United States. As member banks groped their way towards the creation of an Open Market Committee, they bought Treasury bills in 1922 to restore pfrofitability to member banks, old some securities in 1923 in hopes of discouraging gold-inspired inflation; purchased T bills in 1924 to build their portfolio for future interventions should gold flows threaten stability; and purchased them again in1927, to stimulate European demand for US agricultural products and stave off a recession. Each time the intervention worked pretty much as expected.
What emerged, at least in the theory of open market operations elaborated by Benjamin Strong, Governor of the Federal Reserve Bank of New York, and several associates, was a new picture of the powers and responsibilities of the central bank, one that went well beyond the emergency lender-of-last resort duties it had taken over from the banks’ own clearing houses. It now seemed that the Fed could successfully tame the business cycle. As usual, enthusiasts of the new methods were quick to proclaim that one of the fundamental problems of life had been solved.
A central bank that could smooth out the familiar cycle of boom and bust by becoming an attentive player in financial markets “is something unknown to the philosophy, once held, that economic society can be completely served by all hands seeking profit under the stimulus of self interest,” proclaimed A.C. Whittaker, a prominent university economist of the day. The Federal Reserve System, he said, had turned out to be “one of the most brilliant successes” of American institution-building. The fine economic weather of the 1920s – steady growth, stable prices, balanced budgets – was said to be the proof.
Alas, by failing to act as lender of last resort to troubled banks in the wake of the 1929 stock market crash, the Fed was about to precipitate an unprecedented banking collapse. Instead of lending freely to threatened banks – “discounting” their eligible loans in exchange for cash – the Fed took a hard-boiled stance towards banks facing deposit withdrawals. The result was long-lasting depression.
The usual interpretation is the one that Milton Friedman and Anna Schwartz put forward in their A Monetary History of the United States, its crucial chapter recently republished as The Great Contraction (and greatly amplified by Liquat Ahamed’s best-selling Lords of Finance: The Bankers Who Broke the World) .
If [Benjamin] Strong had still been alive and head of the New York Bank in the fall of 1930, he would very likely have recognized the on-coming liquidity crisis for what it was, would have been prepared by experience and conviction to take strenuous and appropriate measures to head it off, and would have had the standing to carry the System with him.
Not everybody agrees. Elmus Wicker, of Indiana University, writing in 1965 in the Journal of Political Economy, shortly after Friedman’s and Schwartz’s famous book appeared, argued that most members of the Open Market Committee had other goals in mind when they voted to authorize its entry into financial markets in 1924 and 1927. And there was no significant discontinuity in the reasoning behind policies that proved successful in one decade and their disastrous consequences in the next. Only long afterwards did the effectiveness of its open market actions as a counterpunch to a looming economic downturn in the ’20s become clear. Friedman and Schwartz never responded to Wicker. And the story of the discovery of open market operations was returned to obscurity.
But its lesson in the present circumstances seems clear enough: old dogs learn new tricks, but only with difficulty. It takes time to devise and master new techniques. The notable expansion of the Fed’s responsibilities in the 1920s worked well for sixty years after World War II – until, in the slow-motion panic of 2007-08, it forgot, however briefly, about its role as lender of last resort. The same process of learning through trial and error that characterized the 1920s may well be taking place with the broader open market operations of today. It should not be surprising that, in a $15 trillion economy, a much bigger balance sheet than before is required to ginger things along.